If They Tax, Do We Relax?

How tax hikes affect productivity.

President Obama released his budget on Monday, projecting a $1 trillion deficit for 2012, and proposing to pay for a temporary fix of the alternative minimum tax by eliminating certain deductions for high-earners. Whenever a politician suggests raising taxes on the wealthy, opponents charge that rich people will work less hard in response. Is that true?

Yes, but it's a relatively small effect. Mainstream economists agree that when marginal tax rates increase, the wealthiest Americans report less taxable income. But little of that decrease has to do with working less hard. For the most part, the rich avoid tax increases by exploiting the complexities of the tax code. They redefine their income to make it nontaxable and get creative with deductions. Sometimes they engage in good-old-fashioned tax evasion. According to economist Jonathan Gruber of MIT, dips in taxable income wipe out more than half of the potential revenue from a tax hike on the affluent, but less than one-fourth of that effect derives from actual losses in productivity.

Here's an example: If the government raised the highest marginal tax rate by 10 percentage points, a couple earning $1 million should pay an additional $62,635 in taxes. But longitudinal studies of individual taxpayer behavior suggest (PDF) they would only end up paying about $28,000 of that increase.

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What happens to the rest? Taxpayers could accept a reduction in cash salary in exchange for a more expensive health insurance plan, since employer-paid premiums are untaxed. They might also claim more deductions by donating to charity or buying a more expensive house. And they could hide some income illegally, by failing to report capital gains or using other means.

All of this aside, a couple might well decide to work a little less in response to a tax hike, since each hour spent at their jobs would yield a smaller reward after taxes. But the available economic research suggests that any drop-off in productivity would account for less than $9,000 of their $35,000 tax savings. Furthermore, most of that would come from the member of the couple who made less money to begin with. Research suggests that primary breadwinners rarely cut their workloads in response to tax increases but that their spouses might give up some hours or even quit their jobs altogether.

Economists refer to this phenomenon as the elasticity of taxable income. In theory, it applies to rich and poor people alike, but the wealthy tend to have an easier time changing their housing arrangements or spending patterns in response to tax-rate increases. Tax evasion is likewise easier for people of means, since a higher percentage of their income comes from self-employment, which isn't always automatically reported to the government on a W-2 form. (They can also speculate in expensive art or stash their cash in offshore accounts rather than investing in easily tracked mutual funds.)

This discussion would be incomplete without a mention of the Laffer Curve, a theoretical chart of tax rates against total government tax revenue apparently sketched on a napkin by economist Arthur Laffer while at a 1974 dinner party with Dick Cheney and Donald Rumsfeld. The idea is that for any desired level of government tax revenue, there are two potential tax rates—a high one and a low one. For example, a zero percent tax rate results in zero government revenue, as does a 100 percent tax rate, since no one would work if the government took all their income. A 1 percent rate would earn the government very little money, as would a 99 percent rate.

The upshot of the curve is that you can't tell what a tax increase will do to total government revenue unless you know which side of the curve you're on. If taxes get too high, then any subsequent hike might end up making revenues go down. While economists have argued endlessly about this theory, it's not particularly important to the current tax debate. Very few economists believe that current tax rates are so high that a small increase would decrease revenue.